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Major Currents in Contemporary Economics

The Monetarist School

Mariusz PróchniakDepartment of Economics II

Warsaw School of Economics

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Background

The Monetarist School

STAGE 1:

The quantity theory of money

Friedman (1956);Friedman and Schwartz (1963)

STAGE 2:

The expectations-augmented Phillips curve

Friedman (1968)

STAGE 3:

The monetary approach to balance of payments theory and exchange rate determination

Johnson (1972);Frenkel and Johnson (1976, 1978)

ORTHODOX MONETARISM

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The traditional approach of the quantity theory of money:

1. The quantity theory of money – traditional approach

MV PY=

where:

M – nominal money supply,

V – the velocity of money circulation in the economy,

P – the average price level in the economy,

Y – real income, output, GDP.

Assumptions:

V = constant.

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1. The quantity theory of money – traditional approach

MV PY=

Implications:

• Given a constant income (which takes place when output is at its potential level), the increase in the nominal money supply leads to inflation.

• The increase in the nominal money supply only raises the nominal income (PY), and not the real income (Y).

• This theory is over 500 years, and according to some economists it even comes from Confucius.

• The monetarists defend it as they argue that inflation is mostly caused by changes in nominal money supply.

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• In 1956, Friedman suggested a restatement of this theory, treating it not as a theory of the general price level or monetary income, but as a theory of the demand for money.

• According to Friedman, the demand for money (like the demand for all other assets) depends on four factors:

� income (which determines the maximum amount of money that people want to have);

� rate of return on money in comparison with the rate of return on other financial and real assets;

� expected rate of inflation;

� consumer preferences.

1. The quantity theory of money – a restatement

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The Friedman’s demand function for real money balances:


( ), , ,D

eMf Y r

Pπ µ=

where:

MD – nominal money demand,

P – the average price level,

Y – permanent income,

r – rate of return on financial assets,

ππππe – expected inflation rate,

µµµµ – consumer preferences.

DM

P– real money demand

Characteristics: The demand for money:

� increases with income,

� decreases with both the rate of return on other financial assets and the expected inflation rate.

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Implications:


Mechanism:

We can explain the ‘core’ of the monetary approach,

i.e. the way the increase in nominal money supply causes inflation.

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The economy is in equilibrium: marginal rates of return on different assets (real and financial) are equal

The central bank increases the monetary base(using open market operations)

The nominal money supply increases

The marginal rate of return on money falls

Individuals get rid of money and buy other assets (e.g. consumer goods)

The prices of these goods increase (INFLATION appears)

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Conclusions:


� The increase in nominal money supply is the main factor stimulating inflation and nominal income growth.

� Given a stable money demand, the instability in the real economy is mainly caused by the fluctuations in money supply, triggered off by the central bank’s policy.

� The money supply should grow at a constant rate corresponding to the real GDP growth rate, leading to long-term price stability.

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Figure 1a The standard textbook Phillips curve

Unemployment rate U

Inflation rate

π

• The standard textbook Phillips curve shows the relationship between unemployment and inflation.

2. The traditional textbook Phillips curve

• The relationship is negative, which means that higher inflation is accompanied by lower unemployment, and vice versa: lower inflation rate corresponds to higher unemployment.

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• The Phillips curve is named after the New Zealand economist Alban William Phillips.

• In 1958, Phillips showed the existence of a statistical relationship between the unemployment rate and the growth rate of nominal wages in the UK during 1861-1957.

• This relationship was negative and non-linear.

2. The original Phillips curve

Figure 1 The original Phillips curve

Unemployment rate U

Growth rate of money

wages W

5.5% 2.5%

2%

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The Phillips curve in mathematical terms:

( )W f U= ( )π = f U

2. The Phillips curve

or

where:

– the growth rate of money wages (dot over a variable means its time derivative),

ππππ – the rate of inflation,

U – the unemployment rate.

W

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• Phillips curve has been used by many Keynesians as an evidence that there is a long-run stable relationship between inflation and unemployment.

• The government may, therefore, pursue a combination of fiscal and monetary policy to choose any point on the Phillips curve, depending on whether the government prefers lower inflation or lower unemployment.

2. The Phillips curve

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• The above reasoning, however, turned out to be false.

• Since the end of the 1960s, past trends in the economy have reversed.

• In the 1970s, both the USA and UK often recorded simultaneous increase in inflation and unemployment.

• The non-existence of a stable long-run negative relationship between inflation and unemployment was observed at the same time by Friedman and Phelps.

• In their opinion, the original specification of the Phillips curve was misleading due to the fact that the rate of increase in money wages does not depend on the rate of inflation.

2. The mis-specification of the traditional Phillips curve

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Figure A1Inflation and unemployment in the USA, 1964-92

2. Some empirics on the Phillips curve

Source: Snowdon, Vane, Wynarczyk (2002), p. 152.

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2. Some empirics on the Phillips curve

Figure A2Inflation and unemployment in the UK, 1964-92

Source: Snowdon, Vane, Wynarczyk (2002), p. 153.

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• In 1968, Friedman suggested that the original Phillips curve was misspecified.

• Although nominal wages are established in wage negotiations, both workers and firms are interested in real, rather than nominal wages.

• Since wage negotiations take place at discrete time intervals, the anticipated real wage depends on the expected rate of inflation during the employment contract.

• Friedman argued that the Phillips curve should include real wages, i.e. it should illustrate the relationship between the growth rate of real wages and the unemployment rate.

2. The expectations-augmented Phillips curve

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• Therefore, Friedman has expanded the analysis of the Phillips curve introducing an additional variable: the expected rate of inflation.

• As a result, the growth rate of money wages depended not only on the unemployment rate (that measures the output gap) but also on the expected rate of inflation:


( ) eW f U π= +

where ππππe is the expected inflation rate.

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� After introducing the expected rate of inflation, we do not have one unique Phillips curve.

� We obtain a family of Phillips curves for different expected rates of inflation.

� For simplicity, we assume that labour productivity growth is zero. Therefore, if nominal wages are constant, price level is constant as well implying a zero expected rate of inflation. In other words:


eW π π= =W = const., P = const.

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Natural rate of unemployment (NARU or U*)Non-accelerating inflation rate of unemployment (NAIRU)


Unemployment rate, U

Growth rate of money wages, W

PC0

PC1

PC2

PC3

PC4

U* NAIRU

π1

π2

π3

π4

Figure 2 The expectations-augmented Phillips curves

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2. The long-run Phillips curve

U

π, W

SRPC0

U* NAIRU

LRPC

SRPC1

E

G F

U1

W1

πe

πe

πe

Figure 3 Short-run and long-run Phillips curves

The long-run Phillips curve is vertical and intersects the horizontal axis at the natural rate of unemployment (U* or NAIRU).

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2. The effects of a monetary expansion

Initial equilibrium – point E:W = const., P = const.; ππππ = 0, ππππe = 0; unemployment – natural (U*), output – potential

U

π, W

SRPC0

U* NAIRU

LRPC

SRPC1

E

G F

U1

W1

πe

πe

πe

Central bank increases the nominal money supply to boost the economy

Aggregate demand and output both increase: output exceeds its potential level

and unemployment decreases to U1

Both prices and nominal wages increase, but prices adjust faster than wages

Workers initially treat the increase in money wages as the increase in real wages and supply more labour

(money illusion); however, real wages decline

Short-run equilibrium – point F

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2. The effects of a monetary expansion

Short-run equilibrium – point F

U

π, W

SRPC0

U* NAIRU

LRPC

SRPC1

E

G F

U1

W1

πe

πe

πe

In the next periods, workers adjust inflationary expectations to the actual rate of inflation

They recognize that real wages have fallen despite the increase in nominal wages; therefore, they insist

to raise their nominal wages

The short-run Phillips curve shifts parallel upwards from SRPC0 to SRPC1

Long-run equilibrium – point G:real wages are at the initial level and the labour market is in equilibrium

Firms fire workers yielding an increase in unemployment

Nominal wages raise at a rate of . Since the growth rate of nominal wages exceeds the actual

inflation rate, real wages raise.

e

1W + ππππ

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� As we can see, a negative relationship between the growth rate of nominal wages and the unemployment rate does not exist if workers – in wage negotiations – fully anticipate future inflation, i.e. when the expected inflation rate equals the actual rate.

� For potential output and natural unemployment, the growth rate of nominal wages is equal to both the actual and the expected inflation rate. Thus, money wages are constant onlyif there are no inflationary expectations.


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� Hence, the long-run equilibrium may occur at any point corresponding to the natural rate of unemployment.

� Connecting these points, we get the long-run Phillips curve (LRPC). It always intersects the horizontal axis at the natural rate of unemployment (U* or NAIRU).

� On the long-run Phillips curve, the growth rate of nominal wages is exactly equal to the inflation rate (i.e. real wages are constant), while the expected inflation rate is equal to the actual rate of inflation (i.e. inflation is fully anticipated).

� The analysis carried out by Friedman helped to combine the existence of the neutrality of money in the long run with the fact that money influences the real economy in the short run.


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� Monetarists assume the existence of adaptive (in other words: error-learning or extrapolative) inflationary expectations.

� The future is an extension of the recent past.

� Workers formulate their inflationary expectations extrapolating past inflation rates.

� E.g. if the government changes its monetary policy, the expected inflation gradually adjusts to the actual inflation and output may vary around the potential level in the short run.

2. Adaptive expectations hypothesis

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� The vertical Phillips curve concerns the long run. In the shortrun, the economy moves along the short-run Phillips curve.

� Monetary expansion could therefore lead to a short-runincrease in output over the potential level and a short-rundecrease in unemployment below the natural rate.

� This outcome occurs because inflation is unexpected(monetarists assume the adaptive expectations hypothesis).

� As soon as workers adjust their inflationary expectations andfully anticipate the inflation rate, the short-run Phillips curvewill shift upwards and the unemployment rate will return tothe natural level.

� Monetarists believe that the economy returns to long-runequilibrium with potential output and full employment during arelatively short period of time (2-3 years).

2. Policy implications of the expectations-augmented Phillips curve

1. The short-run effects of an expansionary monetary policy

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2. The accelerationist hypothesis

� According to this hypothesis, if the government wants to keepoutput permanently above its potential level, such a policy willresult in accelerated inflation.

� This is because the persistent excess of output can only beachieved by a continuous monetary expansion.

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3. The effects of anti-inflationary policy

� Monetarists argue that inflation is a monetary phenomenoncaused by an increase in money supply.

� Thus, the reduction of inflation can be achieved by a decline inthe growth rate of money supply.

� In the short run the economy may deviate from the potentialoutput and full employment, implying that anti-inflationarypolicy will result in a temporary increase in unemployment.

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3. The effects of anti-inflationary policy (cont.)

� The more rapid is the reduction in inflation planned by thegovernment, the higher will be a temporary increase inunemployment and the greater costs of anti-inflationary policy.

� When pursuing anti-inflationary policy, the government facesthe following dilemma:

�� it can reduce inflation rapidly at the cost of high

unemployment,

�� it can choose a gradual (long-run) deceleration of

inflation at the expense of only a small increase in thelevel of unemployment.

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� Initial long-run equilibrium – point E:

�� inflation rate (ππππ1) equals the growth rate of money wages,

�� inflation is fully expected: ππππ1 = ππππe.

Figure 4

The effects of anti-inflationary policy

U

π, W

U* NAIRU

LRPC

SRPC1

E

J

F

SRPC2

SRPC3

H

G K

U1 U2 U3

π1

π2

π3

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1st option: Rapid reduction in inflation



U

π, W

U* NAIRU

LRPC

SRPC1

E

J

F

SRPC2

SRPC3

H

G K

U1 U2 U3

π1

π2

π3

Growth rate of money supply declines sharply

In the short run, the economy moves to the point G and unemployment rises to U3

If workers adjust inflationary expectations, the short-run Phillips curve

will shift from SRPC1 to SRPC3

New long-run equilibrium – point F:unemployment is at the natural level and inflation equals ππππ3

In this policy option, a new inflation target is achieved quickly, but at the cost of high unemployment

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2nd option: Gradual reduction in inflation



U

π, W

U* NAIRU

LRPC

SRPC1

E

J

F

SRPC2

SRPC3

H

G K

U1 U2 U3

π1

π2

π3

Growth rate of money supply decreases initially only slightly

In the short run, the economy moves to point H and unemployment rises to U2

When workers adjust their inflationary expectations, the short-run Phillips curve

will shift downwards to SRPC2

Inflation falls to ππππ2; However, inflation target is ππππ3; Thus, the government

further reduces the growth rate of money supply

In this policy option, the process of reducing inflation lasts longer, but it does not result in a large increase of unemployment as before

The economy moves through K to the new long-run equilibrium point F

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� The third stage in the development of monetarism includes the theory of the balance of payments and exchange rate determination.

� The most important papers have been written by Johnson (1972) and Frenkel and Johnson (1976, 1978).

3. Balance of payments theory and exchange rate determinants

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� The monetarist approach focuses primarily on the money market, at which the interdependence between money demand and money supply is treated as the main factor determining the balance of payments outcome.

� The monetary approach to balance of payments is based on four major assumptions:

� demand for money is a stable function of a specified number of variables,

� in the long run, the economy is in equilibrium with potential output and natural unemployment,

� in the long run, the central bank cannot sterilize or neutralize the impact of the balance of payments deficit or surplus on the domestic money supply,

� the prices of similar tradable goods are equal in all countries in the long run.

3. Monetary approach to the balance of payments (fixed exchange rates)

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The Johnson’s model is based on three major assumptions:

real income is constant at the potential output level and the natural rate of unemployment,

the law of one price holds at the goods and financial markets,

domestic interest rates and domestic prices are pegged to world levels.


A simple model of balance of payments for a small open economy (under the system of fixed exchange rates),

developed by Johnson (1972)

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Demand for real money balances (MD/P) is a function of two variables: real income (Y) and interest rate (r) :


The Johnson’s model (cont.)

( ),DM

f Y rP

=

The money supply (MS) equals domestic credit D plus the money corresponding to changes in foreign exchange reserves (R):

SM D R= +

The money market is in equilibrium when MD = MS.

Then we have:

DM D R= + DR M D= −or

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The effects of an expansionary monetary policy: growth in domestic credit (D)



Initially the economy

is in equilibrium

Since prices, real income and interest rate are exogenous, nominal MD cannot

rise after a domestic credit growth

The excess supply in money market implies

that consumers buy foreign goods and foreign securities

Deficit in the balance of payments

appears

Intervention in the forex market: central bank buys

national currency in exchange for foreign

currency, reducing international reserves

Thus, an increase in domestic credit

results in a decrease of foreign reserves

International reserves decline until the money

market returns to equilibrium and the balance of payments

deficit disappears

In the new equilibrium, the volume of money supply is the same as initially; The increase in domestic credit has been fully offset by a decrease in foreign reserves

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Disequilibria in the balance of payments are automatically adjusted (corrected).

Any discretionary government policy is not needed to improve the balance of payments outcome.

The economy returns to money market equilibrium at the initial level of money supply.

Policy implications (1/3)



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For a small country with fixed exchange rates the national money supply is an endogenous variable.

Monetary policy affects only the structure of money supply (i.e. its division between domestic credit and international reserves), but not the volume of money supply itself.

In a small open economy, monetary policy in the long run does not influence any variable except the size of foreign reserves.

Therefore, expansionary monetary policy does not affect neither inflation rate in a given country, nor the domestic interest rates, nor the rate of economic growth.




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In a world with fixed exchange rates inflation is seen as an international monetary phenomenon.

The source of inflation is the excess of global demand as compared with the level of output, but the excessive demand must result from global, not domestic expansionary monetary policy.

The increase in world monetary expansion (resulting from an expansionary monetary policy pursued by one big country or simultaneously by many small countries) leads to an increase in global demand, causing world inflation.




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� The monetary approach to exchange rate determination is the model of the monetary approach to the balance of payments applied to the floating exchange rates.

� This analysis was explored by Frenkel and Johnson in 1978.

� Under the floating exchange rate system, the balance of payments is always zero.

� Exchange rate adjusts to maintain equilibrium in the forex market: there is neither surplus nor deficit in the balance of payments and international reserves are constant.

3. Monetary approach to exchange rates determination (floating exchange rates)

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� Assuming that output (Y) is constant at the potential level and the interest rate (r) is also constant (it is pegged with the world level), the growth in money demand (MD) may occur only due to the increase in prices (P).


The effects of an expansionary monetary policy: growth in domestic credit (D)

� Hence, monetary expansion leads to higher prices.

see: ( ),DM P f Y r= ⋅

� Given higher prices, higher nominal money demand equals the increased money supply and money market is in equilibrium.

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The effects of an expansionary monetary policy (cont.)

Excess money supply

relative to demand

Higher demand for foreign

goods and securities

At the forex market, the supply of domestic

money increases

A depreciation of national currency

Higher domestic pricesAn increase in nominal

demand for money

Demand for money raises until it equals the increased money supply and the money market equilibrium is restored

The adjustment process

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� The exchange rate between the two currencies depends on the relative money supplies in these two countries.

� E.g. if there were only two countries and both of them increased the money supply by the same amount, the real exchange rate would not change.

� To wrap up, in the system of floating exchange rates, the increase in domestic credit leads to a nominal depreciation of domestic currency and to inflation.


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1. Changes in the money supply are the most important factor responsible for changes in money income and inflation.

2. The economy is inherently stable. However, it can be disturbed by irregular monetary growth. But the economy returns quite rapidly to long-run equilibrium that occurs at potential output and natural unemployment.

3. In the long run, there is no trade off between inflation and unemployment. The long-run Phillips curve is vertical and intersects the horizontal axis at the natural rate of unemployment (or NAIRU).

4. Both inflation and the balance of payments are treated as monetary phenomena.

5. The monetarists are averse to an active stabilisation policy (both monetary and fiscal). The monetary policy should be conducted carefully to ensure long-run price stability.

4. The orthodox monetarism

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1. Monetarism is identified with Milton Friedman. The monetarist school is based on the quantity theory of money. The monetarist approach to the quantity theory of money implies that:

(a) the increase in nominal money supply is the main factor stimulating inflation and nominal income growth;

(b) given a stable money demand, the instability in the real economy is mainly caused by the fluctuations in money supply;

(c) the money supply should grow at a constant rate corresponding to the real GDP growth rate, leading to long-term price stability.

5. Summary

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2. Friedman expanded the original analysis of the Phillips curve introducing an additional variable: the expected rate of inflation. According to monetarists, the traditional Phillips curve showing a negative relationship between inflation and unemployment concerns the short run. The inflationary expectations shift the short-run Phillips curve upwards by a distance equal to the expected rate of inflation. In the long run, the economy behaves according to the long-run Phillips curve, which is vertical and intersects the horizontal axis at the natural rate of unemployment (U* or NAIRU).

5. Summary

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3. Therefore, monetary expansion could lead to a short-run increase in output over the potential level and a short-run decrease in unemployment below the natural rate. As soon as workers adjust their inflationary expectations and fully anticipate the inflation rate, the short-run Phillips curve will shift upwards and the unemployment rate will return to the natural level. Monetarists believe that the economy returns to long-run equilibrium with potential output and full employment during a relatively short period of time (2-3 years).

5. Summary

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4. Monetarists argue that inflation is a monetary phenomenon caused by an increase in money supply. Thus, the reduction of inflation can be achieved by a decline in the growth rate of money supply. But, in the short run, the economy may deviate from the potential output and full employment, implying that anti-inflationary policy will result in a temporary increase in unemployment.

5. Summary

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5. The monetarist approach to the balance of payments implies that for a small country with fixed exchange rates the national money supply is an endogenous variable. Therefore, expansionary monetary policy does not affect neither inflation rate in a given country, nor the domestic interest rates, nor the rate of economic growth. In such a world with fixed exchange rates inflation is seen as an international monetary phenomenon. By contrast, the monetarist approach to exchange rate determination states that in the system of floating exchange rates the increase in domestic credit leads to a nominal depreciation of domestic currency and to inflation.

5. Summary

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• Begg D., S. Fischer, and R. Dornbusch (2005), Economics, London: McGraw-Hill. Polish translation: Begg D., S. Fischer, and R. Dornbusch (2007), Makroekonomia, Warszawa: PWE.

• Snowdon B., H. Vane, and P. Wynarczyk (2002), A Modern Guide to Macroeconomics. An Introduction to Competing Schools of Thought, Cheltenham-Northampton: Edward Elgar.

References

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• Frenkel J.A. and H.G. Johnson (1976), The Monetary Approach to the Balance of Payments, London: Allen and Unwin.

• Frenkel J.A. and H.G. Johnson (1978), The Economics of Exchange Rates, Reading, Mass.: Addison-Wesley.

• Friedman M. (1956), The Quantity Theory of Money. A Restatement, in: Studies in the Quantity Theory of Money (ed. M. Friedman), Chicago: University of Chicago Press. Reprinted in: The Optimum Quantity of Money (ed. M. Friedman), 2007.

• Friedman M. (1968), The Role of Monetary Policy, “American Economic Review”, March.

• Johnson H.G. (1972), The Monetary Approach to Balance of Payments Theory, in: Further Essays in Monetary Economics (ed. H.G. Johnson), London: Macmillan.

• Phelps E.S. (1967), Phillips Curves, Expectations of Inflation and Optimal Unemployment Over Time, “Economica”, August.

• Phillips A.W. (1958), The Relation Between Unemployment and the Rate of Change of Money Wage Rates in the United Kingdom, 1861-1957, “Economica”, November.

Additional references

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Thank you very much for the attention!!!

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